Are UK equities overvalued?

By Trevor Williams, Chief Economist, Corporate Markets

UK equity markets, along with many others around the world, have recovered strongly since their recent low in March 2009. Admittedly, the FTSE All-Share is still well below its 2007 all-time peak and, if one wants to go back further, below the previous peak recorded in 2000. Chart A

However, the fact that UK economic recovery so far seems to be lagging that of some other major economies could lead to doubts about the sustainability of the rise in share prices.

Here, the issue is that with economic recovery not yet assured, a fall in equity prices could hit business and consumer confidence and potentially slow the pace of economic recovery.

A further concern is that the injection of cash into the UK financial system through the Bank of England’s purchase of gilts is leading some to worry that a bubble may be forming in equity markets. We look at some evidence for and against in this Weekly.

Since the 2009 low in March, the UK FTSE All-Share price index has risen by around 50%. Still, this is 23% below the 2007 high and a smaller 16% below the 2000 peak. In other words, the All-Share index is higher but from a relatively low level and so the increase should be seen in perspective. To some extent, the fall may have been exaggerated by fears that have subsequently been proved to be unfounded. Chart B

Nevertheless, it is important for the economy that share prices have recovered from recent lows. The fall in share prices effectively meant a rise in the cost of capital for firms that wished to use equity to raise funds for future investment, to pay bills, to merge with other companies or simply to strengthen balance sheets to reduce bankruptcy risk. Thus, the recovery in the All-Share index since March this year has meant a reduction in corporate funding costs that has helped to reduce the number of corporate failures, ameliorated the rise in unemployment and fall in employment and increased business and consumer confidence. From other lending data, it is apparent that non-financial firms have used some of the funds raised from increased equity issuance to pay down debt owed to banks and other financial institutions. Chart C

What are some of the factors we should be looking at to get a better sense of whether the rise in equities has gone too far? Share prices should, in theory, reflect investors’ expectations of the future earnings (read profits) of companies, discounted to today’s prices.

Hence, there should be at least some correlation between corporate profit performance and share prices. Chart a indicates that this is indeed the case. Here, we use the corporate sector’s gross operating surplus as a proxy for corporate profits.

For the purposes of clarity and exposition, we have indexed corporate profits and the FTSE all share to January 1988 equals 100. A number of things stand out. One, equity prices are more volatile than profits, as to be expected since stocks are traded every day whereas corporate profits are reported quarterly and so will have a smoother profile compared with share prices. Two, there have been periods in which share price growth has been well in excess of profits. Three, when share prices have been in this excess territory a fall back to below profits often occurs. Fourth, this period does not appear to be one of those. Conclusion: share prices relative to profits appear to be close to fair value. Chart D

Another metric we have looked at is the FTSE All-Share price index relative to earnings and then compared this to its long run average, see chart b. This would help to signal whether, in a long run context, it can be said to be cheap or expensive. After a long period in which shares have risen slower relative to earnings, the current ratio is almost bang in line with the long-run average. In other words, share prices have risen relative to company earnings and can be said to be fair value in a long-run sense. Of course, there could be an argument that the return to this average is unjustified and it should be well below it, given the risks that there now are for the economy. For instance, it could be argued that economic conditions in 2009 are a lot worse than they were in 2003, the last time the average was at this level.

We have also compared the ten-year gilt yield with the FTSE All-Share dividend yield, as a measure of relative returns from the two asset classes. Taking the difference back to 2000 suggests that equities are not especially expensive relative to gilts, see chart c. However, neither are they as cheap as they were in the six month period following the collapse of Lehman Brothers last year.

Typically, in the period since 2000, gilt yields have exceeded dividend yields. Although both yields have dropped back since the recession, the fall has been greater in equities than gilts, hence the reduction in the gap and the brief reversal between September last year to about April 2009. Indeed, it could be argued that it is gilts that are expensive relative to equities, given how much yields have fallen and so their prices have risen. It could be that some of this fall in gilt yields reflects official purchases through the Bank of England’s Asset Purchase Facility (APF).

Taking this point about gilts further, what appears to account for the fall in yields? Decomposing the fall between the ‘real yield’ and inflation expectations in the financial markets suggests that although the latter has risen the former has fallen. Chart d shows this starkly. Inflation expectations may have risen because QE is causing inflation concerns to rise. Record gilt issuance amid signs that economic recovery is starting to gain traction in the UK and wider world may also be pushing up inflation concerns. Further the rise in actual inflation under the influence of higher oil prices in recent months could also be a factor.

So why have real yields fallen? That, too, could be because of gilt purchases, which have pushed down yields as demand has been strong. Also, it could be that the real yield is low because short term official interest rates are so low or that economic recovery is not yet assured. But our Risk Appetite Index

(RAI) supports this fall in real yields, with a rise in investor willingness to purchase riskier assets, something that the cut to record low short-term official interest rates was meant to induce.

Finally, using a rolling average 5-year PE ratio juxtaposed against the current PE ratio, strengthens the view that UK equities are fairly priced. Our conclusion therefore is that although shares have revived strongly since March, we should not yet be unduly concerned.

Action to improve economic conditions appears to be having their intended effect and conditions for recovery are increasingly in place.

Share prices seem to be reacting to recovery as much as to increased liquidity. We are not yet in bubble territory, something we would define as share prices being at least 1 to 2 standard deviations above their long-run average. This may mean that as a Committee, the MPC may continue to vote for further QE, if economic growth early next year starts to disappoint their expectations.

 

* All charts are sourced to Lloyds TSB Corporate Markets Economic Research, Bloomberg, IMF and Datastream

 


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